Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

An Empirical Measure of the Real Rate of Interest

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

An Empirical Measure of the Real Rate of Interest

Article excerpt

The interest rate adjusted for expected inflation, the real rate of interest, is a key variable in macroeconomics. It is the price one pays for currently available resources expressed in terms of future resources. How does the real rate of interest behave? Despite the importance of this question, there is no generally available measure of the real rate of interest one can use to answer it. Economists who have studied the real rate have had to create their own series. The purpose of this article is to construct and make available a number of alternative empirical measures of the real rate of interest.

As noted above, the real rate of interest is the difference between the observed market rate of interest and the inflation rate expected by the public. Expected inflation, however, is not directly observable.(1) In order to construct a real rate series, one must select a proxy for expected inflation. We examine two possibilities--inflation forecasts made by Data Resources Incorporated (DRI) and by the staff of the Board of Governors of the Federal Reserve System. The DRI forecasts are made monthly. Through 1978, the Board staff produced monthly forecasts. Thereafter, it produced them eight times per year. These forecast series, therefore, allow construction of real rate series that are observed frequently enough to study cyclical timing relationships.

As an illustration of the usefulness of having a real rate series, we first review recent public debate over the typical level of the real rate. The main part of the article provides a defense of the plausibility of the real rate series constructed here and listed in the appendix. We compare forecasts of inflation from four different sources: the staff of the Board of Governors, DRI, the Michigan Survey of Consumers, and the Livingston Survey. We argue that the broad agreement exhibited among all these series is evidence that the series used here (Board of Governors staff and DRI) have been representative of the expectations of inflation affecting financial markets.

We then discuss other approaches to estimating the real rate. In this context, we examine the predictive ability of the four forecast series. We point out the persistent underprediction of inflation by survey forecasts in the 1970s. We argue that this underprediction does not reflect a basic defect in the survey data, but rather the special difficulty in predicting inflation during the final transition from a commodity to a fiat money standard.


Recently, the behavior of the real rate of interest has become an issue in debates over monetary policy. For example, during Humphrey-Hawkins testimony in July 1993, the chairman of the Federal Reserve System, Alan Greenspan (1993), drew attention to the unsustainably low value of the then current short-term real rate:

Currently, short-term real rates, most directly affected by the Federal Reserve, are not far from zero; long-term rates, set primarily by the market, are appreciably higher, judging from the steep slope of the yield curve and reasonable suppositions about inflation expectations. This configuration indicates that market participants anticipate that short-term real rates will have to rise as the head winds diminish, if substantial inflationary imbalances are to be avoided. (P. 853)

In spring 1994, after the Federal Reserve began to raise the funds rate, controversy arose over what constitutes typical behavior of the real rate of interest. This controversy is illustrated by the following excerpts from The Wall Street Journal.

[W]ith the economy now growing at a robust pace ... the Fed has concluded that it is time to take the foot off the accelerator and put monetary policy into a "neutral" stance.... Robert Reischauer, director of the Congressional Budget Office, said neutral probably means inflation-adjusted rates of somewhere between 3/4% and 1-1/2%. But chief White House economist Laura Tyson has said that--excluding the anomalous 1980s--inflation-adjusted interest rates "have always been below 1%. …

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